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EU banks’ risk-free debt addiction threatens ECB-led overhaul

Jim Brunsden & Johan Carlstrom

When Europe’s leaders set out in June 2012 to break the “vicious circle” between banks and sovereigns, they left rules for treating government bonds untouched, an oversight that may subvert their drive to prevent a recurrence of the debt crisis.

Under EU rules, banks can rate all debt issued by the bloc’s 28 national governments as risk-free, avoiding any increase in their capital requirements. This encourages so- called carry trades, whereby lenders borrow at low cost from the European Central Bank and plow the money into state debt that offers higher returns.

Twenty months after leaders pledged to change this behavior, banks hold more sovereign paper than ever. ECB President Mario Draghi said in December that when the Frankfurt- based central bank offered about 500 billion euros ($680 billion) of new low-cost liquidity two years ago, lenders used it “mostly to buy government bonds,” rather than for lending to stimulate the economy.

“We are working very hard to try to sever this bank- sovereign link, but the more we examine it, the more it seems that it’s never-ending,” said Sharon Bowles, chairwoman of the European Parliament’s Economic and Monetary Affairs Committee. “At least we’ve got to a position in the last few years that everyone recognizes the problem” of the zero-risk loophole, she said. “Resolving this isn’t easy.”

Domestic euro-area government debt accounted for 4.3 percent of total bank assets in December, according to ECB data, up from 3.5 percent in June 2012, when euro leaders launched the banking union, and from 2 percent in September 2008, when Lehman Brothers Holdings Inc. collapsed, triggering the financial crisis.

For the ECB, the appeal of state debt is a concern as it ponders further stimulus amid anemic consumer-price growth. Draghi said before the central bank would offer more low-cost liquidity, “we will want to make sure that this operation is not going to be used for subsidizing capital formation by the banking system under these carry-trade operations.”

For Draghi, the status of state debt originates with the Basel Committee on Banking Supervision, a group that brings together regulators from 27 nations including the U.S, U.K. and China to coordinate rule making.

Government bonds “in the Basel committee regulation framework are risk-less,” Draghi said last month, making Basel the “natural place” to discuss any changes to the treatment of sovereign debt.

The Basel committee rejects this view. “It is sometimes asserted that the Basel capital framework prescribes a zero risk weight for bank exposures to sovereigns,” the Bank for International Settlements, which houses the Basel group, said in December. “This is incorrect.”

Uldis Cerps, a member of the Basel committee, said the zero-risk weighting for sovereign debt “seems to be more a problem of implementation than rule-making.”

Under Basel rules, “complex banking institutions” are expected to use internal models to measure the risks they face, including on investments in sovereigns, Cerps, who’s also the executive director for banking at the Swedish Financial Supervisory Authority, said in an interview.

“In the absence of good statistics” on possible losses, “many banks have sought and obtained so-called permanent or temporary exemptions” from using internal models, “and that is where the problem has really started” because it opens up the possibility to label sovereigns as risk free, he said.

“But there is nothing fundamentally wrong with the regulatory framework,” Cerps said. “If applied properly, the regulatory framework should result in risk-weighting even for government debt.”

The broad zero-risk loophole in Europe arises from the challenge the euro area faces in applying Basel rules across an 18-country currency union, Bowles said.

Under Basel rules, large banks are required to measure all significant risks using their own models. For “non-significant business units” and asset classes that are “immaterial in terms of size and perceived risk,” an alternative set of rules, the Standardized Approach, can be used, the BIS said.

This second method allows national supervisors to reduce risk weights for sovereigns “provided that the exposures are denominated and funded in the currency of the corresponding state,” according to the BIS. In practice, this can mean driving them down to zero.

In Europe, banks are allowed to use the Standardized Approach permanently for sovereign holdings and to apply a zero risk weight to debt issued by any EU government in any of the bloc’s currencies, the BIS said.

Yet the possibility for lower risk weights for banks’ holdings of debt issued by their home-country government is premised on the central bank’s capacity to print more money to pay its debts.

“This logic was never true within the euro zone, because the central bank isn’t allowed to do monetary financing in a normal way,” said Bowles, who led a bid in 2012 to tighten EU rules on risk-weighting of government bonds.

Banks buy sovereign debt for a variety of reasons. The bonds serve as collateral, providing grease to the wheels of financial markets, and they are a key part of the portfolios banks need to meet liquidity rules.

Yet the EU loophole may distort banks’ behavior by encouraging them to buy riskier debt than they might otherwise, said Patricia Jackson, head of prudential advisory at Ernst & Young LLP in London and a former U.K. member of the Basel group.

“You will never break the links between banks and sovereigns, because banks have to hold sovereign debt,” Jackson said in an interview. “In Europe, the question is: are banks encouraged to hold too much debt from the periphery to get a higher yield?”

European banks outside Italy, whose 10-year debt offers a 203-basis-point premium to German debt of similar maturity, held at least $171 billion of that country’s bonds at the end of September, up from $133 billion a year earlier, according to BIS data consolidated by Bloomberg Industries. Of that amount, German and French banks held $131 billion.

Not all peripheral euro countries have benefited from this infusion, such as bailout-recipient Portugal, which has seen debt held by banks in other EU states gradually diminish to $20.3 billion in the third quarter, even as the premium investors demand to hold its 10-year debt instead of comparable German securities stands at 322 basis points.

And while such debt is treated as risk-free in the EU’s minimum capital requirements, supervisors have other means to prevent lenders underestimating their risks, such as increasing buffers for specific kinds of investments using so-called supervisory discretion under the Basel accords.

As the ECB prepares to assume oversight of euro-area banks in November, it’s conducting a three-part balance-sheet assessment that includes a stress test. In this review, state bonds that banks plan to hold to maturity will be stressed, possibly requiring lenders to hold larger provisions. Bonds intended for sale or trade will be marked down to fair market value. Banks’ sovereign holdings will be disclosed in full, including their maturities, according to the ECB.

A consensus is emerging that the EU loophole for sovereign debt is problematic. Dutch Finance Minister Jeroen Dijsselbloem said that a discussion on this issue is “in full swing.”

“My position is that a standard risk weight of zero for government bonds in own currency isn’t right, but this discussion is very tough and very political as you will understand,” Dijsselbloem told lawmakers Feb. 6 in The Hague.

Bowles said nothing is likely to be done in the near future, especially since strong demand from banks has driven down many governments’ borrowing costs as the euro zone tries to spur growth.

“It’s easy to say that the zero-risk weighting clearly creates perverse incentives,” Nicolas Veron, a fellow at the Brussels-based Bruegel research group, said in an interview. “It’s less easy to say what should be done to replace it.”